The Financial Accounting Standards Board has issued its long-awaited proposal on how companies should recognize credit losses in financial statements calling for a forward-looking approach that will lead to more upfront notice to investors when losses are expected.
FASB's “expected loss” approach is an improvement over today's “incurred loss” approach because it doesn't prevent a financial institution from giving early warnings that loans won't perform, said FASB Chairman Leslie Seidman in a media briefing. One of the key criticisms of the current rules is banks and other financial institutions were prevented during the financial crisis from writing down or impairing loans until some failure to perform actually occurred. “We don't want any barriers to recognize expected losses,” she said. “Unlike today's standard, you would not wait for observable deterioration and you would not limit the estimate to losses expected in the near term.”
According to a FASB summary of the proposal, the new model tells financial institutions or any other type of company holding a loan or other credit instrument to establish an allowance for credit losses that reflect its current estimate of credit losses on its financial assets. The amount of cash flow that the company expects it will not collect would be recognized in the income statement under the proposal. The standard requires companies to consider all available evidence, such as the current risk status of the loan, historical information, and reasonable forecasts, to arrive it its estimate. “We are not requiring any particular method for estimating cash flows,” she said. Rather, the standard would leave preparers to decide what method is most effective or most relevant for their circumstances.
The International Accounting Standards Board is expected to issue its proposal in early 2013, and Seidman said FASB will consider feedback to both proposals as it makes final decisions on the U.S. rule. FASB and IASB were working toward a common approach and settled and a different expected loss model that would have required companies to move loans in and out of categories based on whether deterioration of a particular instrument had already occurred and whether loans were pooled. FASB abandoned the approach in favor of its newly proposed approach, however, when feedback through its outreach process sparked questions and confusion over how items would move among the three categories.
“I'm aware that the IASB has been hearing concerns similar to the concerns U.S. stakeholders articulated earlier this year,” she said. She expects IASB to modify its planned guidance around how items transfer among the categories, however, rather than adopting a plan such as FASB has proposed. “We will be looking at commentary on both approaches,” she said, and FASB plans to take all views into consideration as it decides on the final standard.
FASB expects to issue a companion proposal on classification and measurement of financial instruments in the first quarter of 2013 but the board has not settled on an a target effective date for either standard. “Ideally we would make theme effective at the same time because they are quite related,” she said. Ultimately, the effective dates will depending on the nature and extent of feedback and any changes that might be necessary as a result. “I would anticipate we would allow at least one year of lead time to implement the standard,” she said.
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